Educational Articles

Stock Screen: Highest Yielding REITs - July 20, 2011

Alan G. House
| July 20, 2011

There are a few sectors and industries that income investors can turn to, virtually without fail, to find above-average dividend yields. Real estate investment trusts, commonly referred to as REITs, are one such industry (others include utilities and limited partnerships).

The high dividend payouts in the REIT sector relate to two aspects of these securities. First, REITs, as their name implies, own real estate or real estate-related securities (in the case of mortgage REITs). This asset type is known for its cash flow generation. Second, REITs are structured as pass through entities for tax purposes. This allows these companies to avoid corporate taxation, but requires that the vast majority of earnings be “passed” on to shareholders as dividends. Note that shareholders must pay taxes on the dividends they receive from a REIT as if it were income.

Just because REITs, in general, have a tendency to pay material dividends, doesn’t mean that all REITs pay material dividends. Just as with other sectors, some REITs are geared toward growth and others toward income. To highlight those that are geared toward income, we used the online screening tools of The Value Line Investment Survey to highlight those REITs with the highest current yields.

This list is a good starting point for investors seeking income, but it is important to keep in mind that an above-average yield can be an indication that the market believes the dividend payment is at risk. That said, a high yield can also present a good buying opportunity if a company is merely misunderstood. The screen turned up several interesting REITs, including Annaly Capital Management (NLY), Realty Income Corp. (O), and Mack-Cali Realty (CLI).

Annaly Capital Management is a real estate investment trust that owns and manages a portfolio of mortgage pass-through certificates, collateralized mortgage obligations (CMOs), and other mortgage-related assets. After hedging, the portfolio (as of 12/31/10) effectively consisted of 50% fixed-rate securities, 37% floating-rate, and 13% adjustable rate. Subsidiaries offer diversified real estate, asset management, and other financial services. NLY's yield is currently over 14%, the highest payout out of any REIT under our review.

Annaly’s business model designates it not to take credit risk, as increased short-term rates would raise funding costs and hurt sentiment toward the stock, making interest-rate fluctuations the primary risk. The company keeps getting one reprieve after another in terms of a market move toward increased interest rates.

Annaly correctly figured the Fed would hold off on a tightening monetary policy. A few months ago, interest-rate futures indicated that the fed funds rate might begin to climb by early 2012. However, that measure now suggests rates won’t inch up until later next year. Meanwhile, this REIT has been stocking up on U.S. agency mortgage securities. The company has issued over 180 million common shares this year to raise capital for asset purchases. That cash is then leveraged to buy securities issued by Fannie Mae and Freddie Mac, which are implicitly backed by the federal government.

Spreads between asset yields and the cost of funds remain wide on a historical basis, although asset yields have been drifting down. The prospect of spreads remaining wide well into 2012 hints that the company might well remain in expansionary mode until conditions are ready to change.

Acquisitions are a key part of Realty Income’s strategy. In December of 2010, the company bought some SuperAmerica convenience stores, enabling it to augment its presence in an existing business. By contrast, Realty Income purchased some wineries and vineyards in June of 2010, thereby entering a new area of operation. The $544 million acquisition that the company announced in March included numerous retail properties, but it also brought Realty Income into new kinds of property, including distribution centers and office buildings. Management is attempting to have more diverse operations than its traditional retail focus.

International expansion is also on management’s radar screen. The REIT has made two financing moves in connection with this year’s acquisition. Realty Income raised about $285 million in March via the sale of 8.6 million common shares. In June, it issued $150 million of long-term debt that is due in 2035. Most future financings probably will be needed for acquisitions, although Realty Income is issuing stock for its dividend reinvestment program.

Mack-Cali Realty is a real estate investment trust providing leasing, management, acquisition, development, construction, and tenant-related services for its portfolio. As of the end of 2010, it owned or had interests in 277 properties totaling 32.2 million square feet, plus land for development of around 12 million square feet of commercial space, located primarily in the Northeast United States. Mack-Cali boasts the fifth-highest dividend yield (5.4%) out of the REIT's that made our list.

Although Mack-Cali got off to a bit of a slow start this year, the news isn’t all bad. The REIT recently announced the signing of two large lease agreements in one of its most prestigious properties, the office building at 125 Broad Street in downtown Manhattan. The first, with Continental Casualty, is for an 81,296-square-foot space for 19 years, and the second, with General Reinsurance Corp. is for a 56,106 square foot space for 21 years. At this time, though, it is too early to tell if this represents a sustained occupancy turnaround.

The quality of Mack-Cali’s portfolio will be an asset out to mid-decade. Despite broader softness in suburban office properties, the company’s holdings are well positioned for an eventual turnaround. Concentrated in high-value areas including suburban New York and Washington, DC, CLI’s portfolio might well experience significant demand upswings as a more pronounced recovery takes place over the 3 to 5 years ahead.

At the time of this article's writing, the author did not have positions in any of the companies mentioned.